High costs tarnish Fortescue's appeal

Fortescue has survived last year’s near death experience but remains a sell.

Summary: Despite admirable achievements, its high-cost iron ore means Fortescue still faces risks relating to its debt levels, Chinese demand and wily competition.
Key take-out: Australia’s third force in iron ore carries a heavy debt burden and high costs.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Underperform. (Fortescue Metals Group)

Higher iron ore prices and a lower Australian dollar over the past three months have put a spring in the share price of Fortescue Metals Group but it would be unwise to see the recovery as anything more than an opportunity sell into what will be a short-term recovery.

Over the next few months FMG could move up from its current share price of around $3.78 towards the $4 mark but by the December quarter a new reality will settle on the stock.

The critical issues for FMG include:

  • Its status as the high-cost producer among Australia’s big iron ore miners (see HSBC table of costs).
  • Its heavy debt burden and another delay in selling rail and port assets which would have helped retire some of its debt.
  • A question as to why the promised asset sale has not been completed including the question of whether potential buyers shied away.
  • If a sale is achieved what effect it will have on FMG’s cost of production as the company might carry less debt but will have to pay a third party for rail and port services.
  • FMG’s status as a pure-play iron ore stock which exposes it to China’s steel industry and that country’s slowing construction sector and,
  • The company’s ongoing status as the high-cost producer, because all iron ore miners are cutting costs in preparation for a lower future iron ore price.

The knee-jerk reaction from stockbrokers to yesterday’s third quarter production report from FMG was generally positive, which is hardly surprising as the company is well-practiced in the art of public relations and marketing.

What particularly caught the eye of analysts was the ability of FMG to exceed mining rates and shipments and achieve a 17% reduction in the cash cost of producing a tonne of ore to $US36.01.

It was that cost reduction which has helped boost FMG’s share price despite the company’s failure to finalise the promised debt-reducing asset sale, and an apparent willingness to try and repair its over-stretched balance sheet by retaining a higher proportion of future earnings.

A worrying sign…

The failure to entice a buyer for a part share in FMG’s rail and port assets, known as The Pilbara Infrastructure (TPI), is a worrying sign because it either means FMG has inflated expectations of the value of its infrastructure or potential buyers are concerned about future haulage terms and future tonnage to be hauled.

One description of the situation was that FMG had adopted a “wait and see” attitude on its TPI assets, but waiting for what, a higher offer or, a higher iron ore price?

If it is hope of a further increase in the iron ore price, when most forecasts are for a lower price, then FMG shareholders could be disappointed.

…But HSBC optimistic

HSBC, the bank with closest connections to China, has one of the more optimistic opinions for the future of iron ore suggesting in the latest edition of its Metals Quarterly that a “huge over-supply” of iron ore was unlikely with the price likely to slip from an average this year of $US123/t to $US115/t next year and in 2015 before dipping lower to $US105/t in 2016.

The key to HSBC’s optimism is its argument that no-one in the industry (producers, traders and consumers) are willing to finance significant stockpiles. “We have noticed a tendency in consensus estimates to forecast large, multi-year surpluses and believe this is a supply forecasting error”.

“To put it simply if you can’t sell it, you can’t produce it,” HSBC said.

But even if HSBC is correct in its view that there is limited capacity to fund a stockpile of iron ore that will not stop producers playing a game of “low costs win”, which is why all big iron ore miners are pushing ahead with expansion projects – not necessarily to snatch a bigger share of the market but to achieve greater economies of scale and lower costs per tonne.

Mixed iron ore price forecasts

The optimistic HSBC view of the future iron ore price sits in stark contrast to that of the leading iron ore bear, Goldman Sachs. It is sticking with an average price this year of $US135/t, falling next year to $US115 (the same as HSBC), before dropping off a cliff in 2015 to $US80/t and staying below $US90/t into the future.

What both HSBC and Goldman Sachs (and others) are saying is that the China-driven iron ore boom is over, that the era of super profits from iron ore mining is coming to an end and that in future it will be a game of cost cutting to generate strong returns with high cost producers suffering squeezed margins – and FMG is the high cost producer of globally significant seaborne iron ore exporters.

FMG management, which has always been happy with a higher-than-average risk profile, has become a stock which is effectively a proxy for future Chinese iron ore demand, and a bet that the iron ore price will stay high long enough for earnings to achieve the debt reduction target the company has set for itself if it cannot (or will not) sell a share in TPI.

Reduced to its simplest form an investment in FMG today is a multi-layered wager on:

  • The strength of the Chinese economy.
  • The future iron ore price.
  • On-going cost cutting.
  • Hope that rival miners will be unable to deliver the extra tonnes they have promised, or will slow their expansion projects, and
  • That new producers such as Gina Rinehart’s 55 million-tonne-a-year Roy Hill mine will be delayed.

What FMG delivered yesterday was a solid set of production numbers wrapped in glossy paper, which is the company’s style, and easily illustrated by the opening claim that the company had achieved: “Record results from its outstanding portfolio of assets (which) mark the transformation of Fortescue into a mining company of global scale”.

That might be what management believes, but as the HSBC table of comparative costs shows FMG is not a global cost leader, nor does it have an outstanding portfolio of assets.

FMG is actually one of the world’s higher cost sources of seaborne iron ore with at least four other big producers further down the cost curve, including Brazil’s Vale, BHP Billiton, Rio Tinto and Anglo American – with all rushing to fill the market with their cheaper ore.

The latest quarterly production cost of $US36.01/t will have helped FMG’s financial performance but it is unlikely to have moved the company down the cost curve because its rivals are cutting costs just as fast as it is.

Conclusion

Judging the investment appeal of FMG remains in the same category as it has been for the past 10 years; you either have confidence in the management team led by the company’s founder, Andrew Forrest, or you don’t.

Goldman Sachs, Deutsche Bank and UBS are wary, retaining neutral ratings on the stock with its latest price of around $3.78 already above the UBS 12-month price target of $3.70.

On the other hand, BA Merrill Lynch and CIMB say that FMG will outperform with Merrill Lynch tipping a 12-month share price target of $5.50 and CIMB tipping $4.80.

What investors need to consider its FMG’s capacity to be a serial disappointment which can be traced on the company’s share price on a graph showing price movements since early 2011 with several periods of recovery, but a long-term decline from a high of $7.27 in early January, 2011, to its current price which is roughly half that peak.

Graph for High costs tarnish Fortescue's appeal

What the share price graph shows is the combination of problems dogging FMG; debt, costs, risk and its standing as a “one-trick” iron ore pony fully exposed to a slowing China.

My view is that FMG, despite its admirable achievements, continues to play a risky game which involves too much debt, too much faith in Chinese demand for iron ore and too little respect for rival miners being able to undercut it on price as well as deliver a superior grade of ore.

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